Monetary Policy and Self- Fulfilling Expectations: The Danger of Forecasts

Economists have long argued that the best, surest way for a central bank to do its job is to adopt some sort of rule and stick to it. They reason that a central bank’s short-term objectives may be inconsistent with its long-term goals; a rule should prevent the bank from undermining long-range goals for the sake of short-term results.1 Using a rule also makes a central bank’s actions more transparent. Consider the case of a central bank whose long-term goal is inflation stability. If the bank doesn’t specify its longand short-term objectives, the public is apt to misinterpret the bank’s actions, making inflation stability difficult to achieve. For example, to enhance the market’s functioning over the business cycle, a central bank may make a temporary change, which the public may confuse with a change in the bank’s long-term objective. If no explicit reasons for the bank’s actions are given, public expectations about future inflation have no moorings. But what kind of rule is best for a central bank that wants to achieve stable inflation? One of the earliest, most famous proposals was Milton Friedman’s constant-money-growth rule. He argued that the monetary authority should ignore short-run considerations altogether, because attempts to stabilize inflation—or even output—would ultimately make matters worse. Long and variable amounts of time pass before changes in the money supply affect prices, so monetary authorities cannot be sure when and to what degree their policies take effect. This, ironically, means that stabilization policies would potentially be destabilizing. Milton Friedman concluded that the monetary authority should just commit to expanding the money supply by a constant amount every year. The chronic, widespread instability in money demand that has been apparent to many economists since at least the mid-1970s weakened this position, and the unexpected shift in money demand in the early 1990s signaled its demise. The relationship between money and prices seems less predictable now than it once did. Most policymakers now recognize that a constant-growth rule will not prevent inflation from varying substantially over short and long periods. A growing number of central banks recently have moved toward the idea that they should target the inflation rate directly. For example, Canada, the United Kingdom, Sweden, and New Zealand have all adopted explicit inflation targets. Inflation targeting, however, is an objective, and the best way to achieve it remains controversial. That is, would it be better to respond proactively to stop inflation before it increases or to respond only after